ERISA and Global Benefits
Severance Pay and Employment Taxes: Addressed in IRS Chief Counsel Memo
September 16, 2013
The Global Compensation, Benefits & ERISA Practice Group
When settling employment discrimination claims, employers often struggle with the tax rules. In a recent Chief Counsel Memo (the "CCM") found here, the IRS provided straightforward guidance in the form of the four-step approach, summarized below and that is followed by (1) discussion of the penalties that employers may face, and (2) a quick reference table drawn from examples within the CCM.
Step 1: "Origin of the Claim"?
Employers need to determine the character of the payment, by reference to the nature of the underlying claims. Footnote 6 to the CCM provides that "[p]ayments to employees stemming from employment-related claims are often wage-based" and therefore are "required to be reported on Forms W-2, not Forms 1099-MISC."
Step 2: Gross Income?
General Rule: Severance payments generally result in gross income unless there is an affirmative exclusion. In the employment law context, the most common income exclusions are available for –
damage payments for a former employee's physical injury or physical sickness under Code §104(a)(2), provided the amounts were not deducted in a prior year under Code §213; and
reimbursements to a former employee for medical costs that are excludable from ordinary income.
Attorney's Fees: If any part of a severance payment results in gross income for the former employee, then an allocable portion of any attorneys' fees are also treated as gross income. (CCM PDF page 4.)
Step 3: "Wages" for Employment Tax Purposes?
General Rule: Unless excluded from gross income, severance pay, back pay, and front pay count as "wages" for purposes of FICA, FUTA, and wage withholding, even if the amounts are paid after termination of employment (CCA PDF page 6).
The CCM recognizes in footnotes 2 through 4 that "there is some disagreement in the Federal appellate circuits" on whether the foregoing types of pay result in wages for employment tax purposes.
Attorney's Fees:
If a settlement agreement does not clearly allocate an amount for attorney's fees (or does not involve a claim brought under a fee-shifting statute such as Title VII, the ADEA, or the ADA), then the entire amount of attorney’s fees payable to the former employee will be treated as wages for employment tax purposes.
Employment taxes will not apply (i.e., no "wages") if "an employment-related claim under a fee-shifting statute is settled outside of court and the settlement agreement clearly allocates a reasonable amount of the settlement proceeds as attorney's fees."
Step 4: Reportable on W-2 or 1099-MISC?
An employer settling wage-based claims must generally report the entire payment as W-2 income for the former employee.
However, if the settlement agreement specifically and reasonably allocates amounts for the payment of attorney's fees, then the employer must report its payments for attorney's fees on two Forms 1099-MISC, with one being issued to the former employee and the other being issued to the attorney.
Employer Penalties
An employer's failure to satisfy applicable tax reporting obligations will be subject to penalties under Code §§ 6721(a) and 6722(a) of $100 per failure; increased to $250 for each intentional disregard of the filing requirements.
Quick-reference Table For Attorney’s Fees Reporting (drawn from examples in the CCA)
Attorney's Fees?
"Wages" for Employment Tax Purposes?
Tax Reporting
No Allocation in Settlement Agreement.
Yes - All employment-related severance is subject to employment taxes, unless excluded from gross income.
W-2 to former employee for all severance.
Clear and Reasonable Allocation in Settlement Agreement.
Yes - All employment-related severance is subject to employment taxes, unless excluded from gross income.
W-2 to former employee only for severance paid to the employee.
Form 1099-MISC to employee and to attorney for attorney's fees (each reporting amount paid to the attorney).
No Allocation but 100% Paid to Attorney.
Yes - All employment-related severance is subject to employment taxes, unless excluded from gross income.
W-2 to former employee for all severance.
For 1099-MISC to attorney for full amount (unless settlement/check clearly indicates that the amount is being paid “in care of” the attorney or has similar language.